LECTURE 13: COMPETITIVE MARKETS
SHORT-RUN SUPPLY CURVE OF THE COMPETITIVE FIRM
The rising portion of the firm's MC curve above the AVC curve or shut-down point is or
represents the short run supply curve of the perfectly competitive firm (the heavier portion of the
MC curve labelled s in the bottom panel of Figure 1. The reason for this is that the perfectly
competitive firm always produces where P = MR = MC, as long as P > AVC. Thus, at P = $55,
the firm produces 4.5 units (point N); at P = $45, Q = 4; at P = $25, Q = 3; and at P = $15, Q =
2.5. That is, given P, we can determine the output supplied by the perfectly competitive firm by
the point where P = MC. Thus, the rising portion of the competitive firm's MC curve above AVC
shows a unique relationship between P and Q, which is the definition of the supply curve.
SHORT-RUN FIRM SUPPLY
CURVE Example
A competitive firm short-run supply curve is the marginal cost curve, so long as P >
AVC. Given:
TC = 361,250 + 5Q + 0.0002Q2
TR = 25Q
MR = MC
25 = 5 + 0.0004Q
Q = 50,000
Since the firm is price taker: P = MR = $25
It is clear that the point of minimum AVC is reached in the output range between 15,000 to
20,000, where AVC = 50,000 + 5Q + 0.0002Q2. The minimum point on the AVC occurs at Q =
15,811 and AVC = $11.32, and is found by setting MC = AVC and solving for Q:
LONG-RUN ANALYSIS OF A PERFECTLY COMPETITIVE FIRM
In the long run all inputs and costs of production are variable, and the firm can construct the
optimum or most appropriate scale of plant to produce the best level of output. The best level of
output is the one at which price equals the long- run marginal cost (LMC) of the firm. The
optimum scale of plant is the one with the short run average total cost (SATC) curve tangent to
the long-run average cost of the firm at the best level of output.
On one hand, if existing firms earn profits, more firms enter the market in the long run. This
increases (i.e., shifts to the right) the market supply of the product and results in a lower product
price until all profits are squeezed out. On the other hand, if firms in the market incur losses,
some firms will leave the market in, the long run. This reduces the market supply of the product
until all firms remaining in the market just break even. Thus, when a competitive market is in
long run equilibrium all firms produce at the lowest point on their long-run average cost (LAC)
curve and break even. This is shown by point E* in Figure 2.
Figure 2 shows that at p = $ 25, the best level of output of the perfectly competitive firm is 4
units and is given by point E*, at which P = LAC. Because of free or easy entry into the market,
all profits and losses have been eliminated, so that P = LMC = lowest LAC. Thus, for a
competitive market to be in long run equilibrium, all firms in the industry must produce where P
= MR = LMC = lowest LAC so that all firms break even. The perfectly competitive firm
operates the scale of plant represented by SATC at its lowest point (point E*), so that its short
run marginal cost (SMC) equals LMC also.
MARGINAL COST AND FIRM SUPPLY
Short-run Firm Supply
y Competitive market price (P) is shown as a horizontal line because P=MR.
y Marginal cost schedule is the short-run supply curve so long as P > AVC.
Long-run Firm Supply
y Profit. P=MR = MC
y Marginal cost curve is the long-run supply curve so long as P > ATC.
Perfect Competition and Efficiency
The model of perfect competition achieves efficiency in two ways:
y Allocative efficiency: Price = MC and therefore consumer and producer surpluses
are maximised
y Productive efficiency: In the long run in perfect competition equilibrium output is
produced where average costs are at their lowest point
Welfare economics is the study of how the allocation of economic resources affects the material
well -being of consumers and producers. Competitive markets creates balance between supply
and demand, also maximize the total social welfare of the society derived from such activity. The
measurement of social welfare is closely related to consumer and producer surpluses. Consumer
surplus is the amount that consumers are willing to pay for a given good or service minus the
amount that they are required to pay. Producer surplus is the net benefit derived by producers
from production. Figure 3 shows consumer and producer surpluses. In long run, firm must cover
all necessary costs of production and earn a normal.
DEADWEIGHT LOSS PROBLEM
There is deadweight loss problem associated with deviations from competitive market
equilibrium. A deadweight loss is any loss suffered by consumers or producers that is not
transferred but is instead simply lost due to market imperfections or government policies.
Because deadweight losses are shown as triangles (shown in Figure 4) when linear demand and
supply curves are used, deadweight losses are often described as welfare loss triangles.
Deadweight losses occur when market imperfections reduce transaction volume.
DEADWEIGHT LOSS ILLUSTRATION
Supply = Demand 8000 + 8P = 7000 – 2P
10P = 15000
P = $1,500 Per ton
Supply = Demand 1000
+ 0.125Q = 3500 – 0.5Q
0.625Q = 2500
Q = 4,000 (000) tons
Total Deadweight Loss
Consumer Deadweight Loss
= ½ [(4000 – 3000) * (2000 – 1500)]
= $250,000 (000)
Producer Deadweight Loss
= ½ [(4000 – 3000) * (1500 – 1375)]
= $62,500 (000)
Total Deadweight Loss = Consumer Loss + Producer Loss
= $250,000 (000) + $62,500 (000)
= $312,500 (000)